Archive for December, 2011

Austerity is still the answer but now the question has changed. ‘How do we rescue the country’s economy, eradicate the deficit, and return to growth?’ has been replaced with, ‘how do we ensure that the cost of borrowing doesn’t increase?’

When governments borrow money they do so by selling bonds (gilts). These can best be described as IOU’s where investors buy a certain amount of bonds to be repaid, plus interest (yield), over an arranged period of time. Keeping down this yield is paramount to a government’s ability to repay its debts. If the government becomes insolvent then it will default and trigger the kind of austerity measures currently seen in Greece.

Britain’s coalition is trying to ensure that the country is still seen as a safe haven for money markets. When investors suspect that a country is unlikely to be able to repay its debts then credit lines dry up and the governments have to offer higher yields to convince potential investors that the extra reward merits the enhanced risk. An example would be Italy where a lack of liquidity has led to yields of eight per cent to be repaid in just three years. This contrasts with Britain’s relatively luxurious position of selling, at just over two per cent, bonds that don’t have to be repaid for a decade.

Just how one keeps borrowing down is the dividing point in the country’s political landscape. The Conservative led government hopes that by maintaining their austerity programme to eliminate the structural deficit over the course of the parliament, they are keeping the faith of the markets. But austerity comes hand in hand with lower investment, lower spending and lower growth. The UK economy has flat lined and as a result borrowing has to increase to fill the void left by lower tax revenues. The government’s argument is that avoiding austerity measures and allowing the yield on UK bonds to grow by just one per cent would mean every family in the country paying an extra thousand pounds so Britain could repay its debts.

The Director of the Institute for Fiscal Studies, Paul Johnson, appearing on the BBC’s coverage of the ‘Autumn statement’, noted that due to declining growth increasing the amount Osborne has had to borrow, he has to factor in more cuts than previously to eradicate the structural deficit:

“He’s had to take another 15 billion [pounds] away from public spending in the years after the next election. Now he hasn’t told us how he’s going to do that, he’s simply said that in his forecast he’s taking an extra 15 billion away, that’s enough for the OBR (Office for budget responsibility) to say he will meet his target. Had he not pencilled that in the OBR would have to have said he’s going to miss his targets.”

Osborne’s analysis is that should this happen the effect would be to shake the markets’ confidence.

So what of the opposition?

Polls are currently reflecting the public’s lack of faith in Labour’s economic plan. ComRes found that 21 per cent of people trust Labour with the economy whilst 50 per cent do not. Ed Balls’ argument for his economic philosophy has hit a wall. The party’s message is that spending more and therefore increasing borrowing costs will lead to lower borrowing costs. On the surface the claim appears illogical and they have failed dismally in getting across any sort of economic argument to support the claim.

The coalition has found political capital in claiming that despite inheriting a huge deficit they have maintained a low level of borrowing costs. This appears true when compared with European neighbours like Greece and Italy, but does this tell the whole story?

Today’s bond market:

Price

Yield

US Gov 10 yr

100.00

2.00

UK Gov 10 yr

113.27

2.23

Ger Gov 10 yr

97.23

2.31

The above graph shows that the UK does indeed borrow a similar amount to both the USA and Germany. If the theory of cutting the budget deficit to increase the attraction to borrow follows, then you would expect them to have similar budget deficits:

Budget Deficit (% of GDP)

US

9.3

UK

8.7

Greece

7.0

Germany

1.1

So far so good.

But the US, despite the best efforts of the Republican Party, isn’t following a similar austerity plan to keep favour with the markets.

Upon arrival to the White House President Obama initiated an $800bn bill and recently fought hard for a $447bn package of tax cuts and government spending. Hardly austerity measures and when combined with the life and death struggle to raise the debt ceiling, which had it not been achieved would have led to an American default, would surely deter any nervy investors. Yet that isn’t the case, so Chancellor Osborne’s theory of ‘austerity or exorbitant borrowing costs’ appears to fall down.

The example of America’s economic situation is much more consistent with Britain’s position than the European countries. Britain hasn’t defaulted on its debts for 300 years, it has its own currency, an independent central bank and control of its own monetary policy. Our flexibility is far greater than the likes of Italy and Greece and is as such a far safer economy to invest in.

Economist Paul Krugman believes austerity rain will lead to an austerity flood

Labour will need to work hard to convince the country that stimulus is the way to go with even former Liberal Democrat leader and Keynesian, Lord Paddy Ashdown, subscribing to the government’s argument. During a debate with Alistair Darling in response to the ‘Autumn Statement’ he reiterated the party rhetoric; “debt as high as Italy yet borrowing rate lower than Germany.” Labour has to show that this is a distortion of cause and effect to gain any credibility for their argument. Ashdown’s party has always wanted to join the Euro despite the disadvantages of the loss of a sovereign monetary policy. These monetary conditions are again ignored in the austerity hypothesis. Italy cannot print money into the system in order to devalue; it has no control over interest rates and is tied into a political entity that is forcing austerity measures that only increase the likelihood of default and further disincentivise investors.

The 2008 Nobel Prize winning economist Paul Krugman states in his blog: “it turns out contractionary policy is contractionary after all. As a result, despite all the austerity, deficits remain high. So what is to be done? More austerity!”

Perhaps the Labour Party would be well served to adopt this point in favour of the distinctly less successful ‘too far too fast’ campaign.